As Profits Rose, Investment Lagged Behind
By ZACHARY FRYER-BIGGS and MARCUS WEISGERBER | C
WASHINGTON — The defense industry enjoyed nearly a decade of explosive growth following the Sept. 11, 2001, attacks, but while revenue and profit went through the roof, investment in company-funded research and development stagnated.
A Defense News analysis of R&D spending by top defense contractors shows independent R&D spending declined by nearly a third in percentage terms from 1999 to 2012.
Capital Alpha Partners, a Washington-based financial analysis group, released a report earlier this month containing R&D figures for five of the largest US defense firms covering that 14-year window. Any analysis of R&D investment is difficult because reporting is not standard. For example, some companies include the cost of bidding on contracts; others do not.
But while an imperfect picture, the numbers do show a clear trend away from company-funded or independent R&D (IRAD).
In 1999, Boeing’s defense unit, L-3 Communications, Lockheed Martin, Northrop Grumman and Raytheon spent a combined $2.4 billion on IRAD representing 3.3 percent of sales. By 2012, that combined figure had reached $3.3 billion, almost perfectly matching inflation, which was 40 percent during that period.
But while the R&D dollars matched inflation, they came nowhere near matching the ballooning defense revenues. In 1999, the five firms reported sales of $70.8 billion, but by 2012 that figure was $142.6 billion, more than doubling.
As a percentage of sales, R&D began to drop right as the industry expanded in 2002. Actual spending didn’t fall, but as more money poured in very little was directed toward IRAD.
But the block of five companies employed different tactics. Lockheed spent $822 million in 1999, only to see that number fall to $616 million in 2012. To match inflation, 2012’s spending would have had to rise to $1.15 billion.
Boeing, on the other hand, increased its IRAD spending by 57 percent over that time.
“We are determined to sustain our R&D investment, and selectively grow it, even in the current budget environment,” Dennis Muilenburg, Boeing Defense president and CEO, said in written statement provided by the company. “We are significantly cutting other costs more deeply to drive affordability for our customers and protect R&D.”
Boeing has invested in several defense projects, including a liquid-hydrogen-powered UAV that can fly several days.
But while Boeing is an exception, the overall trend in IRAD follows larger concerns about defense spending, and uncertainty as to where that money will be invested.
“Any company with any sense is going to invest in things that have a market,” said Jacques Gansler, a former Pentagon acquisition chief during the Clinton administration. “If there’s not a market for it, and you’re trying to cut your costs, it’s a reason why companies are cutting back.”
Gansler said one of the biggest shifts has been in the amount of research being done in the commercial sector.
“Today, there’s a spin on effect coming from commercial to defense, there’s a huge amount of investment being made in the commercial world, which we can take advantage of in the defense world,” he said.
The effects of changes to R&D spending take years to manifest, and the impact of IRAD spending decisions on US defense technology likely won’t be known for another decade. But one area where there is already an effect has been in recruiting engineers, said Byron Callan, the analyst with Capital Alpha Partners who conducted the R&D spending research. The defense industry has become increasingly vocal about how fewer students are focused on STEM (science, technology, engineering and math), and how that may eventually harm innovation in the industry.
“Industry yaps about the STEM issues and what’s happening to engineering, but are they really putting their money where their mouth is and providing an environment for engineers where people are going to be excited going to work every day?” he said.
But while executives may want to increase R&D spending, convincing shareholders would likely be difficult, Callan said.
“These are public companies that respond to shareholders who have a keen interest in how operating margins are trending in 2013,” he said. “You wonder how easy that would be for [Lockheed Martin CEO Marillyn Hewson] or [Northrop Grumman CEO Wes Bush] to get on a conference call and say that margins aren’t going to be what people anticipated.”
Because of those pressures, private companies that do not have to report earnings figures may have an advantage, experts said. With less scrutiny on the bottom line, those firms can focus on developing the sorts of products that might produce future profit.
Defense Department officials are becoming more vocal in their focus on making sure companies spend money on R&D, with Pentagon acquisition chief Frank Kendall telling Defense News earlier this month that more focus needs to be given to IRAD.
Gansler, however, said industry has responded with skepticism. “When DoD says to the companies, ‘Why don’t you spend more of your money,’ the companies say, ‘Well, why don’t you spend more of yours?’ ” he said. “It’s a fair reaction.”
There was one cause for optimism in the R&D spending figures: After hitting a low point in 2011, of the five companies previously mentioned, Northrop Grumman was the only one which did not increase IRAD spending for 2012. It would still require massive increases for any of those companies to bring R&D spending back to a percentage of sales seen in the late 90s.
Industry executives have voiced concern that the Pentagon’s focus on purchasing low-cost products is encouraging companies to keep R&D spending low, especially the introduction of concepts like Lowest Price Technically Acceptable bid analysis that promotes cost ahead of overall value.
Others — like Boeing’s Muilenburg — view the larger industry reluctance to spend as an opportunity.
“I believe our R&D strategy sets us apart from our competitors,” he said.